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An article was published Wednesday by Lawrence Weinman entitled “'Buying Dividend Stocks For Income' Arguments Don't Make Sense.” The genesis of the article arose from a set of comments involving several Income Investing “old timers” (myself included) and Lawrence in an article by Kurtis Hemmerling, entitled “Here's How To Get Sustainable 7% Dividend Yields When Markets Crash.”

Mr. Hemmerling’s article was mainly a screen for 7% yields, with a little extrapolation about some of the selections. A polite conversation then ensued in the comments section amongst the typical Income Investing crowd.

Yet we “old timers” in the Income Investing section know how our perfectly pleasant conversations inevitably end up. Without fail a “Dividend Agnostic” pipes up. In truth, as long as the conversation is respectful, we really don’t mind being challenged. Defending one’s position allows one to either bolster their belief, or change what is needed.

There are times, however, where Dividend Agnostics just want to argue. At times we “Dividend Zealots” (as we have been derisively called) are left to wonder what on earth we have ever done to the “other” side that causes so much animosity. I visit the Macro and Bond sections of Seeking Alpha often and rarely find the “growth” or “bond” crowd having to defend the kind of onslaught that’s directed at us, and especially at dividend stock investors.

It was unfortunate that the conversation happened in Kurtis’s article, which addresses stocks with 7% yields. It was unfortunate that the conversation happened in the aftermath of a stock market downturn. Seeking Alpha was all aflutter with article after article addressing the new higher yields of many dividend stocks. There were articles aplenty that were just screens. I have nothing against screens, but the quantity of “screen only” articles left some with the impression that all we do in the Income Investing section is screen for high yield stocks.

The comments on Mr. Hemmerling’s article, and the subsequent reactionary article by Mr. Weinman, really changed no one’s mind on either side. But there was one indisputable fact brought out through the exchanges which came through very clearly: There exist many assumptions about income investors that are just plain wrong. These assumptions - and my own personal need to correct them - are the genesis of this article.

Preamble

Let me state from the outset what I am trying to do, and trying NOT to do.

Positively, I am setting out to:

  • Provide a working definition of income investing
  • Provide an overview of the many types of income investors
  • Provide anecdotes which may correct a few assumptions about income investing

What I am NOT trying to do is:

  • Embarrass, denigrate or belittle any one commentor or author
  • Make assessments of effectiveness of any one style over another
  • Promote one style of investing over another. As such, I have abstained from directly quoting any one commentor or contributor. I am not referencing studies or using statistics. I will not be putting any one method of investing on trial. That’s not the point of this article.

Instead, I will simply lay out the mindset and the methods of income investors. I am letting you know who we are, what we think, and how we practice our craft. This is not a theoretical, academic, logical, or how it “should” be argument. It’s simply - here it is:

What is Income Investing?

It’s assumed that investors know exactly what income investing is, but from the commentary I’m reading, I have to differ. So let’s start from the outset with a valid definition.

The best independent definition of an income investor I could find - a definition I found repeated throughout many other investing websites, was found here on About.com, which says:

The art of good income investing is putting together a collection of assets such as stocks, bonds, mutual funds, and real estate that generates the highest possible annual income at the lowest possible risk. Most of this income is paid out to the investor so he or she can use it in their everyday lives to buy clothes, pay for the mortgage, take vacations, cover living expenses, give to charity, or whatever else they desire.

This definition should (but I’m sure won’t) put to rest the ridiculous and pointless competition between some bond and stock proponents. By definition you are BOTH income investors, BOTH looking to create a stream of income in a way that mitigates each individual’s definition of risk. You are siblings, not rivals, in our family of investors. Papa Market may love one sibling more than another for a time, but over the long haul, most investors witness Papa Market balancing out his love.

Most income investors choose to hold both asset classes during their investing lives, and most of us do not understand, nor are we terribly sympathetic, when the two sides go to battle. Most of us wish you would simply get over yourselves, and let us invest as we see best.

Who are Income Investors?

We all understand income investors hold portfolios of stocks, bonds, funds and sometimes real estate. That is a correct assumption, but not a complete assumption. The real devil comes in the details, and the devilish task of constructing an income portfolio is where we all begin to slog in the mud - and begin to sling it at each other.

Bond proponents don’t understand stock pickers. Dividend growth proponents don’t like bonds. We get entrenched in our positions - akin to where we are politically in the U.S. - and forget that most of us are investing “moderates.” We pick our positions somewhere in the middle.

My own history is this: after years of commenting in the Income Investing section, where most of the articles dealt with common stocks and dividend growth investing, I finally contributed my first article. I had been asked to do so by David Van Knapp and the editors, because my comments revealed a different investing perspective that was not “politically polarized.”

The first task of my first article was to point out the various flavors of income investors. This is by no means an encompassing list; it is just the categories that fit what I was seeing on Seeking Alpha. These are:

  • Dividend Growth – This method is considered the surest path to a secure and growing dividend stream. Dividend growth stocks are primarily common stocks with a “sweet spot” yield

    between 2% to 4% and a dividend payout that increases at least once per year. The motto of the Dividend Growth Investor is: “slow and steady wins the race.”

  • High Yield with High Risk – From my experience, High Yield with High Risk investors fall into three camps: traders, newbies and desperate retirees. The motto of the High Yield with High Risk investor is: “It’s my dividend and I want it NOW!” High Yield investors, however, should heed this warning: unless you understand what kind of stock you are considering, high yield is not a “green light” for a buy. If the stock is not created specifically for high yield (i.e. MLPs, REITs, BDCs), you are risking a loss.
  • (Fixed) Income Investors - These investors value capital preservation and a steady income. They may categorize themselves as high yield (above 5%) or median yield (3 to 5%). They look primarily to bonds, mutual funds and preferred shares for their dividends. The motto of the Income Investor is: “I will create a stable dividend stream while not sacrificing my capital.”
  • Blended Approach – This comes closest to the Five Plus Investor’s method of investing. This kind of investor canvasses the investing universe and holds anything that meets their personal investing goals: common shares, preferred shares, bonds and bond funds, CEFs, mutual funds, even CDs

    and annuities. The motto of the Blended Approach investor is: “Whatever works.”

Even with these four designations, I truly believe there are other “flavors” out there in the woodwork. But we had to start somewhere. Now that we are introduced to the fact that a spectrum of types of income investors exist, we are ready to tackle some assumptions made about income investors.

Assumption #1: You are all looking for high yield, and that’s risky

Response: No. We have already established that there are various flavors of income investors and the ways in which they invest in various yield percentages. We are not all looking for “high yield.” We are looking for the right investment which meets our own individual risk profie.

To assume that we're all looking for "high yields," you first have to come up with a definition of what you are talking about. So - what is high yield? Is it a percentage benchmark above the S&P? Is it anything above what is normally recognized as the “sweet spot” for dividend growth investing (which is a subcategory of dividend investing), which is 3-4%? Is it my definition of high yield, which is 5% or more? What about those “crazy” folks who invest in nothing that yields under 10%? Wouldn’t they think 5% is low?

When you take into account the many ways high yield can be interpreted, what constitutes high yield is completely relative to your own definition of risk. For a growth stock investor, any dividend yield is risky since dividend payments take away from money that could be deployed towards company growth. For a dividend investor, what constitutes a monumental risk for one may be considered a cake walk to another.

Since you cannot pin down or define exactly what is high yield, you certainly can’t assume we all ascribe to it. And while risk in investments can be ascertained independently through ratings agencies, independent analysis and just plain common sense, risk tolerance is absolutely in the eye of the beholder.

Assumption #2: Stock picking is bad. It doesn’t work. You all should buy an index fund instead

Response: Quotes about Warren Buffett and George Soros regarding indexing were used in the articles I mentioned to refute stock picking. Oh, the irony of using the world’s best stock pickers as an example against stock picking…

The very first assumption that is being made is that dividend investors never, or have never, used broad market index funds. That simply isn’t true. Most of us started out with index funds, and many dividend investors still allocate a portion of their portfolio to a broad market index fund. When we are told to buy an index fund, many would say, 'I’m sorry, but I own one already!'

But what exactly is the benefit of an index fund? If the last 10 years are any indication, a broad market index fund has taken you 360 degrees back to the same place you started. The trip may have been safer that way…but you didn’t go anywhere.

Let’s get real about indexing. Every single stock in an index is CHOSEN by someone. The Dow Jones Industrial Average was created by Charles Dow, editor of The Wall Street Journal and founder of Dow Jones & Company, now owned by CME Group. It started with 12 stocks in 1896. Fast forward to today. Of those 12 original stocks, only one remains - General Electric (NYSE:GE). How did that happen? Did Papa Market wave his magic wand and “poof” - the index changed? No. The decisions of what to place in any index - whether Dow, S&P, Russell or other - are made by people.

And what is the definition of a decision to include, or not include, a stock in an index? In essence, it is stock picking. The arbiters of the indices choose what stocks belong in the portfolio of the index, based on an array of parameters, and even those parameters are ones that are decided by humans. There is no facet of creating an index that does not involve some human (and therefore, potentially flawed) component.

Therefore, if stock picking is bad - one should not own an index fund.

Here is what is really being said in Assumption #2 - you aren’t smart enough to pick your own stocks. And frankly, if you as a retail investor view investing as anything less than a part time job - I agree with the advice to just invest in an index. We are talking about your future and ability to support you and your loved ones in retirement. If you are going to stock pick, you better treat your stock picking like your livelihood, because in truth -- it is.

Ironically, much of this negative feedback comes from the bond crowd. A pity, given that many income investors love and own bonds and bond funds (myself included). I am wondering what the mantra will be when the paradigm shifts and it will no longer be a hot bond market. Coming in everyone’s future is an interest rate hike…then another…perhaps even another. What will become then of the capital appreciation power of our bonds? One has to wonder if the prevailing mantra will then be…don’t be a “bond picker”…

Assumption #3: You aren’t beating the indices with income investing

Response: Here is where I’m going to get a little flippant. Do we income investors even care about beating the indices? Income investors, say it together…NO. We typically don’t care if the totality of our portfolio beats the indices.

Do we like to pick investments that have that lovely little squiggly line on the bar chart that exceeds the squiggly line for the S&P? You betcha. But as long as that puppy is paying stable or growing dividends, how our total portfolio performs is less relevant to us than how our income is performing.

That doesn’t mean that, as a group, we don’t care about capital appreciation. As indicated in “Who are Income Investors?”, we come in many flavors. I for one WILL NOT invest in any instrument - bond, CanCorp, stock, ETF, CEF, etc. - unless I can chart out both technically and fundamentally that the instrument will appreciate. Many of us implement trading techniques, and employ capital preservation measures such as stop-losses and options. In truth, although many don’t care about appreciation, some of us care more about it than others.

It’s just that our goals are different from those with growth goals. This is why some in our dividend growth crowd are quite zen to the effects of market depreciation. They hang on to their best dividend performers until a dividend cut, continue to reinvest, and ride out market depressions. They do so because companies with dozens of years of dividend increases have proven to be solid investments. David Van Knapp, David Fish and others - who are successfully retired on dividend growth investments - bear out that success with this strategy supercedes “beating the market.”

Assumption #4: You are making a mistake by buying when yields are high. That means your stock has depreciated. That’s bad

Response: See Assumption #3. Our response is virtually the same. Let’s be clear - we do NOT view the depreciation of the stock as “good.” However, we do appreciate having the opportunity to increase our “yield on cost” - a term that should have been used more often in previous conversations.

Again, we are less concerned with capital appreciation than we are in creating an ever increasing dividend stream. We aren’t planning on selling our holdings to create retirement income. We are planning instead to have our holdings create income for us during retirement. This means we do not indiscriminately sell or trade for profit. We consider carefully our sells, and make them more strategically. We will sell if the growth and financial outlook of the company look grim, or there’s a dividend cut - or frankly, if we find a better opportunity to increase our income.

Don’t get me wrong…if we make a tidy profit with our sell, we love it…but only because we can buy more dividend investments with the cash profit we generated!

Without charting it out in this article (I may in a subsequent post), the math seems obvious and Mickey Mouse, but I’ll go there anyway. If the market prices a stock at $10, and you have $100, you can buy 10 shares. If those 10 shares pay 10 cents per share in a year, I make a buck. If the share price drops to $9 a share, I can buy 11 shares. I make $1.10. That’s more, not less, income on my investment. So I take in stride the depreciation.

Why? Because of a simple truth. Market price is not reality. What you sell the stock for is the realized price. If you don’t sell, the market price is irrelevant. You don’t reap the rewards of appreciation, but neither do you take a loss on depreciation!

In conclusion, there are an infinite number of additional assumptions that cannot be fleshed out in just one article. My goal in this article was neither to address every single flawed argument or unfair judgment against us. As well, I am not contributing this article to inflame any one commenter, contributor or group of investors. My one goal is to clear out misconceptions, not for argument's sake, but that we all may understand our investing styles better.

I have had my say. As such, I am stepping back from the Comments section and allowing you all to have your say. I hope you will join in the spirit of the article and disagree or agree with respect and understanding towards one another.

Source: Debunking Dividend Agnostic Assumptions: Here's What Really Makes Income Investors Tick